Chronicle - Oct 8, 2023
In the face of rampant money printing by governments worldwide, is gold poised for a resurgence?
Just Print the Money
The concept of printing money to finance exorbitant expenses predates modern history. To pay their excessive costs, many Roman Empires devalued the value of gold. Gold was priced at 45 coins per pound by Emperor Augustus. Marcus Aurelius reduced gold's value to 50 coins per pound. Diocletian reduced it to 60 coins once again. Constantine the Great, another emperor, reduced it to 70 coins.
That is for the gold coins. The Romans also used silver coinage. And the debasement of their silver coins is far worse.
The same thing happened during the Great Britain era. The monarch set the gold price at 0.89 pounds per ounce in 1257. As the government's expenses rose, they depressed the price of gold. An ounce of gold cost 4.25 pounds in the 1700s.
By the 1800s, most countries had discovered that they could use paper as money. Paper is far more convenient to use as money than heavy coins. To make it feel authentic, each piece of paper is 'pegged' to gold. It is essentially a government-issued paper backed by gold.
But tying paper to gold is a horrible idea. It makes the financial system rigid and prone to crises. To cure a recession, for example, more paper must be issued in order to purchase more goods and thereby grow the economy. If paper is linked to gold, how can more paper be made?
In 1944, the World War II winners met at Bretton Woods and decided to tweak the gold-standard system. Currencies were linked to the US dollar at variable exchange rates, and the US dollar was pegged to gold. An ounce of gold was set at $35. Why the US dollar? Because the United States was the most powerful military and economic power at the time, it possessed around 75% of global gold reserves.
Unfortunately, history repeats itself. It is always easier to meet expenses by issuing paper than it is to mine for more gold. If everyone agrees that paper may be used as money, why bother tying it to gold?
By the early 1970s, the Bretton Woods system had been abandoned. The US government will not trade gold for dollars.
The Glittering Wars
Why are people in the Roman Empire, Great Britain, and today tolerant of their governments debasing currency and hence their purchasing power? Because the government is doing so under the pretext of legitimate spending.
Wars are one of the most legitimate spending. Roman emperors waged wars against everyone, from Persians to Visigoths. For centuries, Britain vying for influence over Europe with the Habsburg Empire. The US was waging wars against communism, terrorism, and whatever.
The Price of Gold
After Bretton Woods was abandoned, gold became the antithesis of paper money. As more paper was printed, the value of paper fell while gold rose. It also demonstrates that printing more paper is far easier than minting fresh gold or maintaining economic discipline.
So, what is the price of paper money? Interest rates. The seller of money (lender) is paid with interest, whereas the buyer of money (borrower) pay with interest.
More specifically, the price of paper money is the expected real interest rates, or interest rates after factoring in expected inflation. People expect more inflation and lower real interest rates as the amount of paper money expands.
We can conclude that gold is an inflation hedge. The higher the expected inflation, the higher the gold price. In other words, as inflation expectations rise, the expected real interest rate, or the price of paper money, falls, and the price of gold rises.
The chart below explains it all. Gold price and expected real interest rate have inverse relationship. [Get 20% discount of your Koyfin subscription by clicking the link here.]
What’s Next
The printer won’t stop anytime sooner, especially with so much excuses from around the world. In the last three years, COVID-19 aids, Biden’s Build Back programs, and Ukraine aids were the legitimate excuses. What happened over the weekend in Israel, and its subsequent chain of events, can be another excuse.
Maybe it’s time to buy more gold. The Fed may increase rates again, or at least hold it high for longer. But inflation expectation in the next 10 years is more than likely to be higher. This will drive the expected real interest rate dropped and gold price soared.
Israel vs Iran?
As conflict between Hamas and Israel happened suddenly over the weekend, many are worried about spiking oil price and falling stock markets. This event for sure brings more geopolitical uncertainty. All eyes turn to Iran as both major oil producer and supporter of Hamas. What will happen to global market depends on whether this is a short-term conflict and contained in Gaza alone, or is it a bigger war between Israel versus Iran and their allies. Still a big IF.
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